This blog is a commentary on contemporary business, politics, economics, society, and culture, based on the values of Reason, Rational Self-Interest, and Laissez-Faire Capitalism. Its intellectual foundations are Ayn Rand's philosophy of Objectivism and the theory of the Austrian and British Classical schools of economics as expressed in the writings of Mises, Böhm-Bawerk, Menger, Ricardo, Smith, James and John Stuart Mill, Bastiat, and Hazlitt, and in my own writings.

Tuesday, August 15, 2006

The Austrian Economics that Most of Today’s “Austrians” Don’t Know

To the great majority of those who today consider themselves to be supporters of Austrian economics, any suggestion that there are cases in which the direct, immediate determinant of price is cost of production is likely to be greeted as though it were indicative of such profound ignorance as to be cause for scandal. These “Austrians” believe that the prices of factors of production—labor, land, and capital goods of all descriptions—are determined by the prices of their respective products and can never determine the prices of their products.

This, however, was not the view of two of the most important Austrian economists of the 19th and early 20th centuries, namely, Eugen von Böhm-Bawerk and Friedrich von Wieser, who were the two leading disciples of Carl Menger, the founder of the Austrian school. Böhm-Bawerk was also the teacher of Ludwig von Mises, and was probably considered by Mises to be the most important of all Austrian economists, himself included. (Mises, I think, could sometimes be unduly modest about his own enormous accomplishments, which, in fact, surpassed those of Böhm-Bawerk, great as the latter’s were.)

Without further ado, I am simply going to quote Böhm-Bawerk from his masterwork Capital and Interest, using the same quotation I’ve been permitted to use in my own book.

Böhm-Bawerk on How and When Costs Determine Prices

Up to this point in our discussion the law of the value of production goods was developed subject to the simplifying hypothesis that every group of means of production admits of utilization only to one very definite purpose. That hypothesis is in real life only very rarely in agreement with the facts. It is preeminently production goods, far more than consumption goods, which are characterized by egregious heterogeneity. The overwhelming majority of them will be capable of service in several productive fields, some are adaptable to thousands of such productive services. Examples are iron, coal, and above all, human labor. Of course, we have to take these factual circumstances into account in conducting our theoretical investigation. We must observe what modifications, if any, affect the law that the value of a group of goods occupying remote orders is governed by the value of their product.

Let us alter the order of the presuppositions of our typical example accordingly. Someone possesses a rather large supply of means of production of second order (G2). From each of these groups he can produce at will a consumption good of the category A, or one of category B or finally, of category C. He desires, of course, to take advance measures toward balanced provision for his various wants, and will therefore draw simultaneously on various parts of his supply of means of production to produce consumption goods of all three categories. And he will produce amounts in each in accordance with his needs. If there is genuinely balanced provision, the quantities produced will be so regulated that needs of approximately equal importance depend upon the last specimen in each category, and that thus the marginal utilities are approximately equal. In spite of that it is not impossible that there will be differences—possibly even quite considerable differences—in the marginal utilities because, as we already know, the gradation of concrete wants occurring in any one category is not always either uniform or continuous. The first stove in my room will afford me a very considerable utility, say one we might designate with an index of 200. A second stove will afford no utility at all. I shall most emphatically call a halt in providing stoves when I have a single specimen with its marginal utility of 200, even though in other areas provision for needs may see a dropping off of the average of marginal utility to as little as 120 or even 100. And so it is permissible and necessary, if our example is to be true to nature, to assume that the marginal utility of a specimen will be different in each of the categories A, B and C. Let us call it 100 for A, 120 for B and 200 for C.

Now the question arises, “What is the value, under these circumstances, of a group of means of production, G2?”

We have had so much practice with selective decisions of a similar nature that we can give the answer without hesitation. The value will be equal to 100. For if one of the available groups of means of production should be lost, the owner would naturally shift the loss to the least sensitive area. He would not curtail production in category B where he would be sacrificing a marginal utility of 120, and certainly not in category C where the sacrifice would go as high as 200. He would quite simply produce one specimen fewer of category A where the reduction in well-being is only 100. Let us express it in general terms. The value of a unit of means of production is governed by the marginal utility and the value of that product which has the least marginal utility among all those products for the making of which the unit means of production could have justifiably been used.

All the relations which we had declared to be plainly in force with regard to the value of means of production and their products under the simplifying assumption of only a single possible disposition, are therefore generally valid as between the value of means of production and value of its least valuable product.

And what is the situation with respect to the other categories of products, B and C? That question brings us to the origin of the “law of costs.”

If under all circumstances the marginal utility attainable by a good within its own category were determinative, then the categories B and C would have to receive a value divergent not only from that of category A, but also from the value of its costs G2. B would then have a value of 120, C a value of 200. But here we are confronted with one of the cases where, through substitution, a possible loss in one category is transferred to another, and as a result, the marginal utility of the latter becomes determinative for the other as well. Thus, if a specimen of category C is lost, it is not necessary to forgo the marginal utility of 200 which the specimen would have delivered directly. Instead, it is possible to convert one unit of the means of production G2 into a new specimen C, and in its place rather produce one specimen fewer in that category in which the marginal utility, and hence the loss in utility is least. And indeed that possibility becomes a reality. The category in question in our example is the category A. Because of the opportunity which production offers for substitution, a specimen C is therefore not valued in accordance with its own marginal utility of 200, but in accordance with the marginal utility of the least valuable related product, the product A; its value is therefore 100. The same applies, naturally, to the value of category B, and would apply generally to every category of good which is “productionally related” to A, and of which the direct marginal utility is also greater than that of category A.

This leads to some important consequences. The first is that in this way the value of goods having a higher individual marginal utility occupies the same rank as the value of the “marginal product”; and hence also the same rank as the means of production from which both emanate. The identity which exists in principle between “value” and “costs” therefore obtains in this instance as well. But it is to be carefully noted that here the coinciding is brought about in quite a different way from that which was followed in the case of costs and marginal product. In the latter instance the two coincide because the value of the means of production accommodates itself to the value of the product. The value of the product is the determinant factor, the means of production is the factor that is determined. In our present case it is the other way around, and it is the value of the product that must do the accommodating. Ultimately it accommodates only to the value of another product. But initially it accommodates also to the value of the means of production from which it emanates and which brings about its substitutional connection with the marginal product. The transmission of value proceeds, so to speak, along a broken line. First it goes from the marginal product to the means of production, fixes the value of the latter, and then ascends in the opposite direction from the means of production to the other products which it is possible to produce from them. In the end product, then, the products of higher immediate marginal utility derive their value from their means of production. Let us translate the abstract formula into terms of concrete practice. Good B or good C is, in general, a product of higher immediate marginal utility. If now we consider what good B or C is worth to us our first response is, “Just exactly as much as the means of production are worth to us from which we can at any moment replace the product.” If we then inquire further and ask how much the means of production themselves are worth, we arrive at the marginal utility of the marginal product A. But on innumerable occasions we can spare ourselves this further inquiry. Time and again we already know the value of the goods that comprise the cost, without any necessity for working it out from its foundation and proceeding onward from case to case. And on all these occasions we simply determine the value of products by their costs, and in doing so we are taking advantage of an abbreviation which is as accurate as it is convenient.

And now the whole truth about the celebrated law of costs is revealed. It is indeed quite correct to say that costs govern value. Only it is imperative to remain aware of the limits within which this “law” is valid and of the source from which it derives its virtues. In the first place it is only a particular law. It is valid only so long as the possibility is present of furnishing, through production, substitute specimens in any quantity and at any time they are desired. If there is no possibility of substitution, then in the case of each product, value must be determined by its immediate marginal utility in its own category. In that case its value no longer coincides with that of the marginal product and of the intermediate means of production. Therein lies the explanation of the empirically established principle that the law of costs is valid only for the goods that are “reproducible at will,” and that it is a law of only approximate validity. For it does not bind the goods over which it holds sway to slavishly meticulous adherence to costs. On the contrary, it permits fluctuations above and below such costs, depending on whether production at the moment lags behind demand or outstrips it.

A second and still more important consideration is that even where the law of costs is valid, those costs are not the final, but only an intermediate cause of the value of goods. In the last analysis, they do not give value to their products, but receive it from them. That is clear as crystal in the case of production goods for which there is only one productive use. Surely no one will wish to deny that it would be erroneous to assert that Tokay wine is valuable because Tokay vineyards possess value; everyone will concede that the truth is the other way around, and those vineyards have a high value because their product is highly valued. It is just as hopeless to deny that the value of a quicksilver mine depends on that of the quicksilver, the value of a wheatfield on that of wheat, the value of a brickkiln on that of brick, and not vice versa. Only because of the manysidedness of most cost goods is it possible for the situation to present the opposite appearance. As the moon reflects the light of the sun upon the earth, so do the manysided cost goods reflect the value which they receive from their marginal product on their other products. (Eugen von Böhm-Bawerk, Capital and Interest. 3 vols., Sennholz and Huncke translation (South Holland, Illinois [Grove City, Pennsylvania]: Libertarian Press, 1959), vol. 2, pp. 173-176. Quoted with permission of Libertarian Press. See also ibid., vol. 3, Excursus 8, and Böhm-Bawerk’s article “Value, Cost, and Marginal Utility,” George Reisman, trans., Quarterly Journal of Austrian Economics, vol. 5, no. 3, pp. 43-45.

As I wrote in Capitalism, what Böhm-Bawerk has shown in these passages is that when the price of goods whose own, direct marginal utility is extremely high is determined on the basis of cost of production, precisely then is its value determined on the basis of marginal utility—the marginal utility of the means of production used to produce it, as determined in other, less important employments. The buyer of an automobile fan belt or any other essential automotive part, for example, does not pay a price corresponding to the value he attaches to his car, but a much lower price corresponding to the marginal utility of the materials and labor required to produce fan belts or whatever—a marginal utility that in turn is determined by the marginal utility of products other than fan belts or whatever. As Böhm-Bawerk develops the law of diminishing marginal utility, it is no more surprising that the price of vital components and parts, or any necessity, is in conformity with its cost of production rather than its own direct marginal utility than it is that the marginal utility of the water on which our physical survival depends is no greater than the utility of the marginal quantity of water we use. Determination of price by cost is merely a mechanism by means of which the value of supramarginal products is reduced to the value of marginal products. The only complication is that the marginal products in this case are physically different and lie in other lines of production.

Here I must add that Böhm-Bawerk’s demonstration has the potential to accomplish two very major results: One, is to overthrow the core of contemporary “microeconomics” and its fixation on “marginal revenue” and the concomitant alleged ability of all significant sized firms to exploit marginal revenue at the expense of consumers. Böhm-Bawerk’s doctrine implies that wherever there is legal freedom of entry into an industry, the concept of marginal revenue becomes largely irrelevant. Price will be determined on the basis of cost, irrespective of the degree of inelasticity of demand and potential willingness of buyers to pay higher prices.

The second major result is a very substantial narrowing of the gap that is perceived as separating Austrian economics from British classical economics. As I’ve shown throughout Capitalism, there is enormous value in classical economics that has been overlooked for no genuinely good reason. If what is of value in classical economics could be added to the already great strengths of Austrian economics, the result would be a far more powerful defense of economic freedom and assault on statist intervention than is now possible.

But the most important, the overriding and sufficient reason for accepting Böhm-Bawerk’s analysis here is simply that it is profoundly enlightening—it’s the enlightenment yielded by the principle of marginal utility all over again, on a higher plane.